The Financial Markets' Confidence Game

All investing is a confidence game. You give your money to someone else who invests it. You hope the investment prospers, and you further hope that you are rewarded with interest, dividends and capital gains. You trust that the person to whom you give your savings will use it diligently, and account for it honestly. This was true at the end of the Middle Ages, when rudimentary forms of the partnership were used in northern Italy to finance merchants' journeys to the Low Countries to trade in wool products and other goods. It's also true today, when European banks create off-balance sheet vehicles and raise money from investors to purchase interests in American subprime mortgages. It you don't have the necessary trust, you won't have investment.

Without this dynamic, businesses could not obtain the vast amounts of financing needed to conduct commerce on a national and international scale. In 1607, the Virginia colony was financed by a company chartered by King James I, which raised its money from investors. In the 1800s, much of the financing for America's railroads came from British investors. America in those days was a relatively poor country, and Britain, with its global empire, was fabulously wealthy. There was lots of capital in Britain, and the economic potential of the North American continent couldn't be overlooked.

That remains true today. America is still seen as a good place to invest. This, even though we have an enormous balance of trade deficit with the rest of the world. Americans buy huge amounts of manufactured goods from other countries, which accept dollars in return. Foreigners have to do something with those dollars. While the dollar is the international currency, and large quantities of dollars are exchanged between foreigners (such as when China buys oil from Middle Eastern nations), trillions of dollars come back here to be invested in the U.S. financial markets. As we discussed in our preceding blog (http://blogger.uncleleosden.com/2007/08/were-subprime-mortgage-risks-hidden.html), the international connectedness of the financial markets means that when a fast-talking mortgage broker convinces an unsophisticated borrower to sign up for an adjustable rate mortgage that the borrower can't repay (but which generates a large commission for the broker), a German bank that set up an Irish affiliate to invest in U.S. asset-backed securities may take a loss.

The fact that so much of the impact of the subprime mortgage mess has been felt overseas greatly complicates the Federal Reserve's job. A reduction of the target fed funds rate, now ardently sought by many in the financial markets, would likely cause the dollar to drop in value. That could lead investors to withdraw capital from dollar denominated investments, which would put downward pressure on the financial markets. Of course, many would cheer if the Fed lowered its target for the fed funds rate, and their good cheer would have upward impact on the financial markets. What would result from these countervailing forces? No one knows.

On the other hand, holding the line on the fed funds rate would likely keep many in the financial markets morose. People in bad moods can be unpredictable, and a loss of confidence could lead to more credit crunches and stock market drops. Foreign investors who lose confidence in the U.S. markets could withdraw their money. That, too, would put downward pressure on market prices. And--get this--many U.S. hedge funds might abandon their dollar-denominated investments and turn to foreign markets because they might make more money that way. (Please don't bring up patriotism; we're talking about money, here.)

One thing that seems clear is that the central banks of the industrialized nations have been in close communication with each other. Events indicate that they basically agree on a strategy. The strategy apparently is to maintain interest rates at current levels until the lay of the land becomes clearer. A month or two ago, the central banks of some nations may have been considering interest rate increases. Today, those moves are on hold. The central banks have also agreed to diffuse credit market panics. Note that they've moved swiftly to provide liquidity when needed.

Yet, at the same time, they have not lowered interest rates generally, because they want to dispel the notion that they will bail out people who make bad investment decisions. The hedge fund operators, bankers and other folks who were at the forefront of investing in CDOs are smart, well-educated people. They'd love to dump the cost of their mistakes on their governments (and the taxpayers that support those governments). Needless to say, they wouldn't have shared their profits had those investments turned out well (except, perhaps, for whatever paltry taxes they might be required to pay). Lowering interest rates could give the smart money exactly what it wants, at everyone else's expense. The perpetuation of the Federal Reserve put might create even larger long term problems as increasingly large asset bubbles pop up with greater frequency. The Federal Reserve wants to combat this perception and make the markets healthier by forcing people to bear, of all things, risks as well as rewards.

The financial markets' confidence game has now become a government confidence game. The central banks of the world, and especially America's Federal Reserve, have to convince investors that they are on the ball, and will do the right thing. A lot of people would be pleased to see Maserati-driving, $1,000 a bottle champagne drinking hedge fund operators bear the risks that they created with their voracious appetites for mortgages that couldn't be repaid. And many would cheer the central banks if they made these fair-weather risk takers experience adulthood and suffer losses of their own creation. But the rub is that if the explosions set off by the fast-money boys are so great that they do major collateral damage to civilians, then ordinary folks would expect the central banks to step in and prevent panic.

The financial markets, on a systemic level, are now a confidence game played by governments. Forget the notion that markets are best left undisturbed by government intervention. The financial system as it now exists is a creature of government policy. The question isn't whether there will or will not be government involvement. That question was resolved when the Federal Reserve was created in 1913. The only question now is what the government involvement will be.

The central banks, and the rest of us, are in a quandary because so little is known about the derivatives market and the hedge funds. The belief that derivatives and hedge funds shouldn't be regulated has resulted in the creation of a monster. The Fed's current obsession with monetary policy, while appropriate and necessary, only treats the symptoms. The Fed struggles because it still doesn't know how big the monster is or where all of its tentacles extend. With the lack of regulatory mechanisms in place, the Fed and other financial regulators can't even take an x-ray, let alone do a CT scan or an ultrasound. All they can do is keep the patient on life support and hope that the immune system revives itself.

The panic among investors stems from the same lack of information. They don't know how bad the damage from the subprime mortgage mess is. This lack of information creates panic, which, in turn, fosters an irresistible urge to sell. It's one thing if a public company announces it has a problem. Hypothetically, let's say a pharmaceutical company announces the failure of crucial clinical trials of a much touted product in development. That doesn't mean the company's stock is a sell. Maybe you should buy more after the stock price drops because you think the company's long term potential remains positive. On the other hand, if you hear through the rumor mill that the company is in trouble but you can't get any details, then selling may be a sensible thing to do. And that's what many hedge fund investors are doing. In an environment where they can't get much information, it makes sense to sell.

Will the subprime mortgage mess eventually lead to regulation of derivatives and of hedge funds and similar investment vehicles? Only time will tell. For posterity, though, let's remember the confusion and uncertainty of these times, when the lack of regulation and information forced the world's central banks to play the biggest confidence game of all.

Celebrity News: Helmsley dog gets $12 million, but two grandkids get zip. http://www.wtop.com/?nid=456&sid=1234185. Did the house plants get anything?